Oct. 6 (Bloomberg) -- Bill Gross’s Pimco Total Return Fund,
the world’s biggest mutual fund, is trailing a low-cost Vanguard
index fund this year as some of the top bond investors were
blindsided by the rally in Treasuries.

Gross’ fund returned 1.5 percent this year through Oct. 4,
compared with 8.9 percent for the $10.4 billion Vanguard
Intermediate Term Bond Fund, which outperformed 99 percent of
intermediate bond funds tracked by Chicago-based Morningstar
Inc. The Vanguard fund, which tracks an index rather than trying
to beat it, topped managers including Loomis Sayles & Co.’s Dan
Fuss and TCW Group Inc.’s Tad Rivelle.

“At the beginning of the year I don’t think many managers
would have said Treasuries are the place to be or that the yield
on the 10-year would go to 2 percent,” Douglas Swanson, manager
of the $21 billion JPMorgan Core Bond Fund, said in a telephone
interview from Columbus, Ohio. His fund gained 6.5 percent this
year.

The Vanguard fund, which beat 95 percent of funds over the
past five years, won because it held bonds with longer
maturities than rivals and three times as many Treasuries. While
that allocation may hurt returns when interest rates start to
rise, the fund’s performance highlights the growing challenge to
fixed-income managers from the passive strategies that have
already grabbed a fifth of U.S. stock fund assets.

Bond funds have been shielded from indexing competition
because unlike stock funds, they showed steady gains over the
past decade, Chris Philips, a senior analyst at Valley Forge,
Pennsylvania-based Vanguard, said in a telephone interview.
Intermediate bond funds gained an average of 5 percent a year in
the 10 years ended Oct. 4, Morningstar data show.

Less Efficient

Index funds account for about 9 percent of bond fund
assets, Morningstar data show, compared with 19 percent for
stock funds. Funds run by stock pickers including Legg Mason
Inc.’s Bill Miller and Kenneth Heebner of Capital Growth
Management LP have experienced redemptions of $290 billion since
the end of 2007, after they failed to protect investors from two
bears markets in the past decade.

Bond markets are harder to track because of the number of
securities in many bond indexes, said Gregory Davis, a principal
in the bond indexing group at Vanguard. The Barclays Capital
U.S. Aggregate Bond Index has about 8,000 bonds, Davis said. The
Vanguard fund that mimics it has about 5,000 holdings.

The bond market is also less efficient than the stock
market, said Morningstar analyst Eric Jacobson, because of the
number of bonds outstanding and the complexity of the
instruments. In theory, that should give active managers an
advantage over index funds, he said.

‘Quietly Disappoint’

That hasn’t happened over the past five years, when just 25
percent of bond funds beat their benchmarks. That compares with
52 percent of equity-fund managers who outperformed, according
to Lipper, a Denver-based research firm. A majority of actively
managed bond funds failed to match their benchmarks in 10 of the
last 11 years, according to Lipper. Active funds with 10 years
of performance lagged behind the benchmarks by an average of
0.45 percent per year, Lipper data show.

“They quietly disappoint,” said Jeff Tjornehoj, senior
research analyst at Lipper, in an e-mail.

The $9.7 billion Natixis Loomis Sayles Investment Grade
Bond Fund, co-managed by Fuss, returned 2.6 percent this year
through Oct. 4, Bloomberg data show. The $15.8 billion
Metropolitan West Total Return Bond Fund, co-managed by Rivelle,
gained 4.1 percent. Fuss’ fund had no money in Treasuries as of
July 31. Rivelle had 9 percent in Treasuries as of June 30,
according to Morningstar. Both funds trailed their benchmarks in
2011, Bloomberg data show. They beat more than 90 percent of
rivals over 5 years and 10 years, Morningstar data show.

Hot Treasuries

Coming into 2011, most bond managers assumed the U.S.
economy would grow at a faster pace and that interest rates
would rise, said Colin Lundgren, head of fixed income at
Minneapolis-based Columbia Management Investment Advisers LLC,
where he oversees $170 billion in bonds. To prepare for that
scenario, they cut Treasuries and added corporate bonds, which
are less sensitive to rates, he said.

“We have been in a massively unusual environment which
made Treasuries very hot,” Morningstar’s Jacobson said in a
telephone interview from Overland Park, Kansas. “Most managers
didn’t want to hold a lot of Treasuries because they yielded so
little.”

Treasuries outperformed corporate bonds and mortgage bonds
in 2011, data from Bank of America Merrill Lynch indexes show,
and bonds with 5-10 year maturities topped bonds with shorter
due dates. Over the past five years, longer maturities also did
better.

‘Sweet Spot’

“We have been in the sweet spot,” Vanguard’s Davis said
in a telephone interview.

The Vanguard fund tracks the Barclays Capital U.S. 5-10
Year Government/Credit Float Adjusted Index. As of Aug. 31, the
fund had 52 percent of its money in Treasuries, 3 percent in
government agency securities and most of the balance in
corporate bonds, Davis said. The average intermediate bond fund
had 15 percent of its assets in Treasuries as of June 30,
Morningstar data show.

The Vanguard fund has an average duration of 6.4 years
compared with 4.8 years for the typical intermediate bond fund,
according to Morningstar. Duration is a measure of how much the
price of a bond will change when interest rates rise or fall.
Morningstar defines intermediate bonds as those with maturities
between 4 and 10 years.

“Declining interest rates have overwhelmed everything
else,” Margie Patel, who manages more than $1 billion in stocks
and bonds for Wells Capital Management Inc., said in a telephone
interview from Boston. Bonds with longer maturities are more
sensitive to changes in rates, Patel said.

Gross’s ‘Mistake’

Gross, co-chief investment officer at Pacific Investment
Management Co., had been reducing the vulnerability of his Total
Return Fund to interest-rate swings and increasing its reliance
on credit quality since July 2010 by shifting from Treasuries to
corporate and non-U.S. sovereign debt.

The strategy backfired in August as the U.S. economy slowed
and Europe’s debt crisis worsened. The $242 billion Pimco Total
Return Fund trailed 80 percent of rivals so far in 2011,
according to Bloomberg data.

The fund’s Treasury holdings fell to zero as of February
and in March Gross used derivatives to bet against the
securities. Treasuries climbed to 16 percent of the portfolio in
August, according to the website of the Newport Beach,
California, firm.

In August, Gross told the Financial Times that it was a
“mistake to bet so heavily against the price of U.S. government
debt.”

Cost Advantage

The Total Return Fund has a different benchmark than the
Vanguard index fund, though it has the freedom to invest in the
same bonds. Total Return normally stays within two years of the
duration of the Barclays Capital US Aggregate Index, which was
5.2 years as of June 30, according to the fund’s prospectus. The
aggregate index is the main benchmark for most intermediate bond
funds, according to Morningstar. Total Return beat that
benchmark over 5 and 10 years, Bloomberg data show.

With most active managers underperforming and bond yields
at or near record lows, the case for using index funds is just
as compelling in fixed income as it is in stocks, said
Vanguard’s Philips. Bond index funds will match the market’s
performance over time and gain an edge through lower costs, he
said.

The Vanguard Intermediate Bond Fund index charges a fee of
22 cents for every $100 invested compared with a weighted
average of 59 cents for actively managed rivals, according to
Lipper.

“In a world where bonds are only yielding 2 percent, that
cost advantage is important,” Philips said.

Long-Term Record

The top active managers are still ahead over longer
periods. Over five years, Pimco Total Return and Vanguard
Intermediate Term Bond fund both gained about 7.7 percent a
year, Bloomberg data show.

Over 10 years Gross’ fund beat the index fund by roughly 10
basis points annually, Morningstar data show; over 15 years it
won by about 25 basis points per year. A basis point is equal to
.01 percentage point.

Mark Porterfield, a Pimco spokesman, did not respond to
messages seeking comment.

Jeffrey Gundlach, founder of Los Angeles-based DoubleLine
Capital LP, is one of the few managers of an intermediate bond
fund who has topped the Vanguard index fund this year. His $720
million DoubleLine Core Fixed Income Fund returned 9.8 percent
in 2011, Bloomberg data show. The fund had 17 percent of its
assets in Treasuries as of Aug. 31, Morningstar data show.

Gundlach on Top

Gundlach managed the TCW Total Return Fund from 1993 to
2009. It was the top-performing intermediate bond fund for the
15 years ended Nov. 30, 2009, with an annual return of 8.3
percent, according to Morningstar.

While acknowledging that Treasuries have been winners this
year, Colin Lundgren of Columbia Management said the trend may
not hold.

“For Treasuries to continue to outperform, we will need to
see more bad news,” said Lundgren, who expects corporate bonds
to outpace Treasuries over the next 6 to 12 months.

Investors in the Vanguard Intermediate Bond Index Fund need
to temper their expectations, said David Falkof, a Morningstar
analyst who follows the fund.

“If rates rise, this fund will not fare as well as its
peers,” he said in a telephone interview.